Financial challenges in the legal sector

Financial challenges in the legal sector

May 20, 2014

Solicitors could be forgiven for wondering where the next hammer blow will fall, after a terrible year since the introduction of the Jackson reforms to civil procedures in April 2013. The impact of this and savage legal aid cuts have triggered a wave of failures, a consolidation surge as larger firms like Slater & Gordon have gobbled up smaller players and rescues such as Penningtons’ acquisition of Manches. Then a full blown professional indemnity insurance crisis broke last October, which led ultimately to the closure by the Solicitors Regulation Authority of well over 100 firms at the end of December.

In the mid-market, a surreal form of merger mania is taken hold, with one survey revealing that 75% of such firms in Manchester had either made or received an approach in the second half of 2013. Nationally, we have learnt of tie ups in just the past few months alone between Lawrence Graham/Wragge & Co, CMS Cameron McKenna/Dundas & Wilson, Bond Pearce/Dickinson Dees and Charles Russell/Speechly Bircham; the list is seemingly endless and the failed merger discussions are equally prolific.

Now there is potentially the most serious threat of all, with the HMRC tightening of the tax regime for LLPs or more specifically their non-equity or ‘salaried members’. The cash flow strain for their firms from the changes will be immediate, with PAYE and 13.8% employer national insurance contributions on their drawings to account for each month.  The professional press and social media have been overwhelmed with stories of prominent firms forced to rush through substantial cash calls on partners.  The changes were only announced in December 2013 and come into force with effect from 6 April 2014.  The timing could hardly be worse for the UK legal profession.

As recently as September 2013, research published by financial health monitoring specialists, Company Watch showed how fragile the finances of law firms were. The survey covered the latest published accounts of 2,600 law firms operating as limited companies or LLPs.  The results were startling.  A third of the firms (898) were in the Company Watch Warning Area, indicating that they had a one in four chance of failing or undergoing a financial restructuring during the next three years.  Smaller law firms were the most vulnerable, with the research confirming that half (463 out of 932) of firms with assets of less than £100k were in the Warning Area.

Additionally, 488 law firms (19% of the sample) had liabilities which were greater than their assets. A third of smaller firms fall into this category, which is the commercial equivalent of a house owner in negative equity. They were only surviving with the support of their creditors, but were technically insolvent on one of the two statutory tests. One leading London chambers was so struck by the publication of these financial data that it was prompted immediately to instigate a system of proactive credit checking of solicitors introducing work to its barristers.

The concern these statistics should cause is that they are historic, relating to accounts for trading periods which mostly ended in 2012. As such they reflect a legal market damaged by four years of recession, but before the injurious effects of Jackson, legal aid cutbacks, raised professional indemnity premiums and now the imminent cash outflows resulting from the change of the partnership tax regime. What might the comparative figures look like in another year or eighteen months?

The better news is that NatWest have announced that they are open for lending to personal injury law firms, reacting to concerns about a cash flow crisis in that particular market. The reality of this may of course be less encouraging, dependent as it will be on due diligence, risk assessment and the lending terms they may impose, but it encouraging never the less. The last two years have also seen the arrival of some innovative lenders prepared to provide funding for more routine costs in civil litigation, augmenting the specialist third party funders who will support major pieces of litigation.

In a curious way, this moment of financial crisis may be the making of the future legal profession as old practice methods are swept away by new efficiencies, much of it driven by the technology which some more traditional firms have been slow to adopt. Alternative business structure alliances with outside investors and trade or professional services partners from different disciplines are developing apace, bringing new management and commercial techniques to the law.

Unfortunately, one thing is certain. There will be further casualties, but the impact on the partners and their staff will be substantially mitigated by the earliest possible recognition of financial problems and prompt action to seek specialist advice so that positive options can be explored while they are still available.